Use Market Weakness to Buy Great Companies at a Discount

On Monday the market pundits were heading full speed for the exits.  Italy’s election and bearish Fed meeting notes were blamed for the sell-off.  Adding further uncertainty was the looming sequester.  For two days the sky was falling and as they are wont to do the experts extrapolated short-term data to conclude the market had moved too far too fast.  That was Monday.  
 
Tuesday the DJIA rose 115.96 points (.84%) and Wednesday the index rocketed 175.24 points or 1.26%.  The reasons subsequently proffered were clarification from the Fed that it would continue easing (read:  the Fed will continue to buy treasuries and mortgage-backed securities to ensure interest rates stay at current historically low levels) thereby forcing investors seeking yield and total return into riskier assets, like stocks.  Traders believe this is good for the market.  And, bam, the rally that wasn’t suddenly is once more.  
 
For individual investors this head-spinning day-to-day volatility is no way to make stock buy and sell decisions. We can’t compete with Wall Street traders.  Nor do we have to.  
 
When the frenzy begins, step back and take a good look at your portfolio.  Are you properly diversified?  Do you have an inordinate concentration in tech stocks, for example?  Or in one holding?  Are you missing exposure to a particular industry, say cyclicals?  If so, take a look at  the industry leaders to determine if there are any bargains to be had.  After the election in November when investors were worried about the impact of rising taxes and the then Washington crisis du-jour, the looming “fiscal cliff,” the market sold off and I saw an opportunity to increase my holdings in cyclical stocks (among other industries).  
 
Caterpillar (CAT) was coming off a lackluster year and the trailing p/e on the stock was hovering around 9x 2011 earnings, a significant discount to its historical average of 15x trailing earnings.  Analysts, while admitting it was one of the deepest discounts ever applied to the stock, were also quick to cite the global economic slowdown as a reason not to own the stock.  But the price was already reflecting those concerns.  I began picking away at the stock and continued to buy as it went up.  My average cost is $86.99.  The stock recently spiked at close to $100 and has come back to the low $90’s closing yesterday at $92.49.  If it spends more than a few days below $90 per share I’ll be adding to my position.  
 
As a long-term investor I don’t need CAT to return 50% in six months.  I am look for 10-12% per year which means that some years I may get 3% and some years I may get 20% or a decline of 10% but, every year I will be collecting my (currently) 2.25% dividend yield which beats money market or intermediate bond returns and I have the potential for dividend growth and price appreciation. 
 
Of course there is the risk the stock will decline.  In fact, because it is a cyclical stock and its earnings are subject to the ups and downs of the economy, I expect to experience periods when the stock declines.  That is why I own a portfolio of stocks and why I only purchase shares of well-managed companies.  However, good management will find a way to get the company back on track.  And they almost always do.  I am owning this stock for the total return it will produce over the next ten to twenty years not the next few weeks.  Look at the chart below courtesy of  Wells Trade.  I have selected the longest period availble and compared the performance of CAT with the S&P 500.  You will note that some short-term periods have not been good for the stock (or the market for that matter) but over the long-term, in good economic times and bad, CAT has produced an enviable return.  
 
 
Price chart, Wells Trade
 
I am willing to take the short-term risk when I buy high-quality companies at discounted price levels.  Frequently the lower price already reflect the risk.  As I repeatedly told my teenagers:  learn to manage expectations and you will increase your chances of success.  Stocks that Wall Street hates,  if their managements adequately manage expectations, often provide great long-term opportunities.
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